BIPRU 2.2 is for the most part written on the basis that GENPRU 1.2 (Adequacy of financial resources) applies to a firm on a solo basis. However it is still relevant when GENPRU 1.2 applies on a consolidated basis. When GENPRU 1.2 applies on a consolidated basis, BIPRU 2.2 should be read with appropriate adjustments.

ensure that the processes, strategies and systems required by the overall Pillar 2 rule and used in its ICAAP, are both comprehensive and proportionate to the nature, scale and complexity of that firm's activities (GENPRU 1.2.35 R); and

Where a firm is a member of a group, it should base its ICAAP on the consolidated financial position of the group. The group assessment should include information on diversification benefits and transferability of resources between members of the group and an apportionment of the capital required by the group as a whole to the firm (GENPRU 1.2.44 G to GENPRU 1.2.56 G (Application of GENPRU 1.2 on a solo and consolidated basis: Processes and tests)). A firm may, instead of preparing the ICAAP itself, adopt as its ICAAP an assessment prepared by other group members.

reviews the arrangements, strategies, processes and mechanisms implemented by a firm to comply with GENPRU, BIPRU and SYSC and with requirements imposed by or under the regulatory system and evaluates the risks to which the firm is or might be exposed;

(2)

determines whether the arrangements, strategies, processes and mechanisms implemented by the firm and the capital held by the firm ensures a sound management and coverage of the risks in (1); and

(3)

(if necessary) requires the firm to take the necessary actions or steps at an early stage to address any failure to meet the requirements referred to in (1).

In both of the cases in BIPRU 2.2.17 Gcapital resources should be calculated in the same way as they are in GENPRU 2.2 (Capital resources). This includes the rules limiting the amount of capital that can be included in the various tiers of capital when capital resources are being calculated.

In the circumstance set out in BIPRU 2.2.20 G, the appropriate regulator may ask a firm for alternative or more detailed proposals and plans or further assessments and analyses of capital adequacy and risks faced by the firm. The appropriate regulator will seek to agree with the firm appropriate timescales and scope for any such additional work, in light of the circumstances which have arisen.

Monitoring the use of a firm'scapital planning buffer is also a fundamental part of the appropriate regulator supervision of that firm. A firm should only use its capital planning buffer to absorb losses or meet increased capital requirements if certain adverse circumstances materialise. These should be circumstances beyond the firm's normal and direct control, whether relating to a deteriorating external environment or periods of stress such as macroeconomic downturns or financial/market shocks, or firm-specific circumstances.4

identify and consider that firm's largest losses over the last 3 to 5 years and whether those losses are likely to recur;

(b)

prepare a short list of the most significant risks to which that firm is exposed;

(c)

consider how that firm would act, and the amount of capital that would be absorbed, in the event that each of the risks identified were to materialise;

(d)

consider how that firm'sCRR might alter under the scenarios in (c) and how its CRR might alter in line with its business plans for the next 3 to 5 years;

(e)

consider whether any of the risks in the overall Pillar 2 rule is applicable to the firm (it is unlikely that any of those risks not already identified in (a) or (b) will apply to a firm whose activities are simple);

(f)

document the ranges of capital required in the scenarios identified and form an overall view on the amount and quality of capital which that firm should hold, ensuring that its senior management is involved in arriving at that view; and

(g)

(in order to determine the amount of capital that would be absorbed in the circumstances detailed in (c)) carry out simple sensitivity tests where the firm analyses the impact of a shift in the key risk parameters identified in (b) on the earnings of the firm.

(3)

A firm is also expected to form a view on the consolidated amount of capital it should hold as well as the capital required to be held in respect of each of the individual risks identified under the overall Pillar 2 rule. For that purpose, it may conservatively sum the results of the individual tests performed in (2)(c). If the firm chooses however to reduce that sum on the understanding that not all risks will materialise at the same time, then the firm should perform scenario tests that demonstrate that a reduction in capital is legitimate.

(4)

A firm should conduct stress tests and scenario analyses in accordance with GENPRU 1.2.42 R to assess how that firm's capital and CRR would alter and what that firm's reaction might be to a range of adverse scenarios, including operational and market events. Where relevant, a firm should also 3consider the impact of a severe 3economic or industry downturn on its future earnings, capital resources and capital resources requirement,3 taking into account its business plans. The downturn scenario should be based on forward looking hypothetical events calibrated against the most adverse movements in individual risk drivers experienced over a long historical period.3

having consulted the management in each major business line, prepare a comprehensive list of the major risks to which the business is exposed;

(2)

estimate, with the aid of historical data, where available, the range and distribution of possible losses which might arise from each of those risks and consider using shock stress tests to provide risk estimates;

(3)

consider the extent to which that firm'sCRR adequately captures the risks identified in (1) and (2);

(4)

for areas in which the CRR is either inadequate or does not address a risk, estimate the additional capital (if any) needed to protect that firm and its customers, in addition to any other risk mitigation action that firm plans to take;

(5)

consider the risk that that firm's own analyses of capital adequacy may be inaccurate and that it may suffer from management weaknesses, which affect the effectiveness of its risk management and mitigation;

(6)

project that firm's business activities forward in detail for one year and in less detail for the next 3 to 5 years and estimate how that firm's capital and CRR would alter, assuming that business develops as expected;

(7)

assume that business does not develop as expected and consider how that firm's capital and CRR would alter and what that firm's reaction to a range of adverse economic scenarios might be (see GENPRU 1.2.30 R to GENPRU 1.2.43 G (the overall Pillar 2 rule and related rules and guidance)). Where appropriate, the adverse scenarios should consider the impact of market events that are instantaneous or occur over an extended period of time but which are nevertheless still co-dependent on movements in economic conditions3;

(8)

document the results obtained from the analyses in (2), (4), (6), and (7) in a detailed report for that firm's senior management, and, where relevant, its governing body; and

(9)

ensure that systems and processes are in place to review against performance the accuracy of the estimates made in (2), (4), (6) and (7).

This paragraph applies to a proportional ICAAP in the case of a firm whose activities are complex.

(2)

A proportional approach to that firm'sICAAP should cover the matters identified in BIPRU 2.2.26 G, but is likely also to involve the use of models, most of which will be integrated into its day-to-day management and operation.

(3)

Models of the sort referred to in (2) may be linked so as to generate an overall estimate of the amount of capital that a firm considers appropriate to hold for its business needs. For example, a firm is likely to use value at risk models for market risk (see BIPRU 7.10), advanced modelling approaches for credit risk (see BIPRU 4) and, possibly, advanced measurement approaches for operational risk (see BIPRU 6.5). A firm might also use economic scenario generators to model stochastically its business forecasts and risks. A firm may also link such models to generate information on the economic capital desirable for that firm. A model which a firm uses to generate its target amount of economic capital is known as an economic capital model (ECM). Economic capital is the target amount of capital which maximises the return for a firm's stakeholders for a desired level of risk.

(4)

A firm is also likely to be part of a group and to be operating internationally. There is likely to be centralised control over the models used throughout the group, the assumptions made and their overall calibration.

(5)

The more a firm integrates into its business such economic capital modelling, the more it is likely to focus on managing risks for the benefit of its stakeholders. Consequently, ECMs may produce capital estimates that differ from the amount of capital needed for regulatory purposes. For the appropriate regulator to rely on the results of a firm's models, including ECMs, a firm should be able to explain the basis and results of its models and how the amount of capital produced by its models reflects the amount of capital needed for regulatory purposes. It may be that those amounts are not equal. Where they are not equal, the appropriate regulator will expect a firm to discuss any differences with the appropriate regulator. However, it may prove difficult to reconcile the outcome of a firm's modelling with the appropriate regulator's own assessment of the adequacy of that firm's capital. This may be the case when, for instance, matters of judgment are involved in arriving at a firm's capital assessment, or the appropriate regulator relies on information which cannot be fully disclosed to the firm (for example comparisons with the firm's peers). Nevertheless, a firm whose ECM produces a different amount of capital to that required for regulatory purposes is still obliged to comply with the overall Pillar 2 rule. A firm should therefore be able to explain to the appropriate regulator how the outcome of its ECM is adjusted so that it complies with the overall financial adequacy rule and the overall Pillar 2 rule.

(6)

Stress testing should provide senior management with a consolidated view of the amount of risk the firm is or might be exposed to under the chosen stress events. Senior management should therefore be presented with information that considers the possibility of the risks materialising simultaneously in various proportions. For instance, it would be misrepresentative to simulate market risk stressed events without considering that, in those circumstances, market counterparties may be more likely to default. Accordingly, a firm could:

(a)

carry out combined stress tests where assets and liabilities are individually subjected to simultaneous changes in two or more risk drivers; for instance, the change in value of each loan made by a firm may be estimated using simultaneous changes to both interest rates and stock market or property values;

(b)

integrate the results of market and credit risk models rather than aggregating the results of each model separately; and

(c)

consider scenarios which include systemic effects on the firm of wider failures in the firm's market or systems upon which the firm depends and also any possible systemic effects caused by the firm itself suffering losses which affect other market participants which in turn exacerbate the firm's position.

(7)

Furthermore, if a complex firm uses an ECM it should validate the assumptions of the model through a comprehensive stress testing programme. In particular this validation should:

(a)

test correlation assumptions (where risks are aggregated in this way) using combined stresses and scenario analyses;

(b)

use stress tests to identify the extent to which the firm's risk models omit non-linear effects, for instance the behaviour of derivatives in market risk models; and

(c)

consider not just the effect of parallel shifts in interest rate curves, but also the effect of curves becoming steeper or flatter.

A firm may take into account factors other than those identified in the overall Pillar 2 rule when it assesses the level of capital it wishes to hold. These factors might include external rating goals, market reputation and its strategic goals. However, a firm should be able to distinguish, for the purpose of its dialogue with the appropriate regulator, between capital it holds in order to comply with the overall financial adequacy rule, capital that it holds as a capital planning buffer and capital4 held for other purposes.

The calibration of the CRR assumes that a firm's business is well-diversified, well-managed with assets matching its liabilities and good controls, and stable with no large, unusual or high risk transactions. A firm may find it helpful to assess the extent to which its business in fact differs from these assumptions and therefore what adjustments it might be reasonable for it to make to the CRR to arrive at an adequate level of capital resources.

Interest rate risk arising from non-trading book activities

A firm should assess its exposure to changes in interest rates, in particular risks arising from the effect of interest rate changes on non-trading book activities that are not captured by the CRR. In doing so, a firm may wish to use stress tests to determine the impact on its balance sheet of a change in market conditions.

Securitisation risk

A firm should assess its exposure to risks transferred through the securitisation of assets should those transfers fail for whatever reason. A firm should consider the effect on its financial position of a securitisation arrangement failing to operate as anticipated or of the values and risks transferred not emerging as expected.

Residual risk

A firm should assess its exposure to residual risks that may result from the partial performance or failure of credit risk mitigation techniques for reasons that are unconnected with their intrinsic value. This could result from, for instance, ineffective documentation, a delay in payment or the inability to realise payment from a guarantor in a timely manner. Given that residual risks can always be present, a firm should assess the appropriateness of its CRR against its assumptions which underlie any risk mitigation measures it may have in place.

Concentration risk

A firm should assess, and monitor, in detail its exposure to sectoral, geographic, liability and asset concentrations. The appropriate regulator considers that concentrations in these areas increase a firm's exposure to credit risk. Where a firm identifies such concentrations it should consider the adequacy of its CRR.

When assessing liquidity risk, a firm should consider the extent to which there is a mismatch between assets and liabilities.

BIPRU 2.2.36G01/01/2007

A firm should also, when assessing liquidity risk, consider the amount of assets it holds in highly liquid, marketable forms that are available should unexpected cash flows lead to a liquidity problem. The price concession of liquidating assets is of prime concern when assessing such liquidity risk and should therefore be built into a firm'sICAAP.

Business risk: General

A firm'sCRR, being risk-sensitive, may vary as business cycles and economic conditions fluctuate over time. A deterioration in business or economic conditions could require a firm to raise capital or, alternatively, to contract its businesses, at a time when market conditions are most unfavourable to raising capital. Such an effect is known as procyclicality.

To reduce the impact of cyclical effects, a firm should aim to maintain an adequate capital planning buffer4 during an upturn in business and economic cycles such that it has sufficient capital available to protect itself in unfavourable market conditions.

To assess its expected capital requirements over the economic and business cycles, a firm may wish to project forward its financial position taking account of its business strategy and expected growth according to a range of assumptions as to the state of the economic or business environment which it faces. For example, an ICAAP should include an analysis of the impact that the actions of a firm's competitors might have on its performance, in order to see what changes in its environment the firm could sustain. Projections over a three to five year period would be appropriate in most circumstances. A firm may then calculate its projected CRR and assess whether it could be met from expected financial resources. Additional guidance on capital planning over an economic and business cycle can be found in GENPRU 1.2.73A G (Capital planning).3

Business risk: Stress tests for firms using the IRB approach

A firm with an IRB permission must ensure that there is no significant risk that it will not be able to meet its capital resource requirements for credit risk under GENPRU 2.1 (Calculation of capital resources requirements) at all times throughout an economic cycle, including the capital resources requirements for credit risk indicated by any stress test carried out under BIPRU 4.3.39 R to BIPRU 4.3.40 R (Stress tests used in assessment of capital adequacy for a firm with an IRB permission) as being likely to apply in the scenario tested. For the purpose of deciding what capital resources are or will be available to meet those credit risk requirements from time to time a firm must exclude capital resources that are likely to be required to meet its other capital requirements under GENPRU 2.1 at the relevant time. A firm must also be able to demonstrate to the appropriate regulator at any time that it is complying with this rule.

If a firm's current available capital resources are less than the capital resources requirement indicated by the stress test that need not be a breach of BIPRU 2.2.41 R. The firm may wish to set out any countervailing effects and off-setting actions that can be demonstrated to the satisfaction of the appropriate regulator as being likely to reduce the difference referred to in the first sentence. The appropriate regulator is only likely to consider a demonstration of such actions as credible if those actions are set out in a capital management plan based on the procedures in GENPRU 1.2.73A G (Capital planning) 3and including a plan of the type referred to in 3GENPRU 1.2.73A G (5)3that has been approved by the firm's senior management or governing body.

The countervailing factors and off-setting actions that a firm may rely on as referred to in BIPRU 2.2.44 G include, but are not limited to, projected balance sheet shrinkage, growth in capital resources resulting from retained profits between the date of the stress test and the projected start of the economic downturn, the possibility of raising new capital in a downturn, the ability to reduce dividend payments or other distributions, and the ability to allocate capital from other risks which can be shown to be negatively correlated with the firm's credit risk profile.

In considering if there are any systems and control weaknesses and their effect on the adequacy of the CRR, a firm should be able to demonstrate to the appropriate regulator that all the issues identified in SYSC1 have been considered and that appropriate plans and procedures exist to deal adequately with adverse scenarios.

Risks which may be considered according to the nature of the activities of a firm

An asset management firm

When assessing reputational risk an asset manager should consider issues such as:

(1)

how poor performance can affect its ability to generate profits;

(2)

the effect on its financial position should one or more of its key fund managers leave that firm;

(3)

the effect on its financial position should it lose some of its largest customers; and

(4)

how poor customer services can affect its financial position; for example, a firm which has outsourced the management of customer accounts may want to consider the impact on its own reputation of the service provider failing to deliver the service.

As an asset manager's mandates become more complex, the risk of it failing to comply fully with the terms of its contracts increases. In the event of such failure, a firm can be exposed to substantial losses resulting from customers' claims and legal actions. Although the appropriate regulator would expect an asset manager to have in place adequate controls to mitigate that risk, it may also like to consider the potential cost to it should customers claim that it has not adhered to mandates. Past claims and compensation may provide a useful benchmark for an asset manager to assess its sensitivity to future legal action. In assessing the adequacy of its capital, an asset manager may therefore consider whether it could absorb the highest operational loss it has suffered over the last 3 to 5 years.

In relation to the issues identified in BIPRU 2.2.63 G, an asset manager should consider, for example:

(1)

the direct cost to it resulting from fraud or theft;

(2)

the direct cost arising from customers' claims and legal action in the future; an asset manager could consider the impact on its financial position if a legal precedent were to encourage its customers to take legal action against that firm for failing to advise correctly on a certain type of product; the relevance of such scenarios is likely to depend on whether the asset manager is acting on a discretionary basis or solely as advisor; and

(3)

where it has obtained professional indemnity insurance, the deductibles and individual or aggregate limits on the sums insured.

The appropriate regulator expects an asset manager to consider the impact of economic factors on its ability to meet its liabilities as they fall due. An asset manager should therefore develop scenarios which relate to its strategic and business plan. An asset manager might therefore consider:

(1)

the effect of a market downturn affecting both transaction volumes and the market values of assets in its funds; in assessing the impact of such a scenario, an asset manager may consider the extent to which it can remain profitable (for example, by rapidly scaling down its activities and reducing its costs);

(2)

the impact on current levels of capital if it plans to undertake a significant restructuring; and

(3)

the impact on current levels of capital if it plans to enter a new market or launch a new product; it should assess the amount of capital it needs to hold, when operating for the first time in a market in which it lacks expertise.

A securities firm

A securities firm may consider the impact of the situations listed in (a) to (c) on its capital levels when assessing its exposure to concentration risk:

(a)

the potential loss that could arise from large exposures to a single counterparty;

(b)

the potential loss that could arise from exposures to large transactions or to a product type; and

(c)

the potential loss resulting from a combination of events such as a sudden increase in volatility leaving a hitherto fully-margined client unable to meet the margin calls due to the large size of the underlying position and the subsequent difficulties involved in liquidating its position.

(2)

An example of the analysis in (1)(b) relates to a securities firm which relies on the income generated by a large, one-off corporate finance transaction. It may want to consider the possibility of legal action arising from that transaction which prevents the payment of its fees. Additionally, an underwriting firm may, as a matter of routine, commit to place a large amount of securities. It may therefore like to assess the impact of losses arising from a failure to place the securities successfully.

Where a securities firm deals in illiquid securities (for example, unlisted securities or securities listed on illiquid markets), or holds illiquid assets, potentially large losses can arise from trades that have failed to settle or because of large unrealised market losses. A securities firm may therefore consider the impact of liquidity risk on its exposure to:

Counterparty risk rules only partially capture the risk of settlement failure as the quantification of risk is only based on mark-to-market values and does not take account of the volatility of the securities over the settlement period. A securities firm's assessment of its exposure to counterparty risk should take into account:

(1)

whether it acts as arranger only or whether it also executes trades;

(2)

the types of execution venues which it uses; for example, the London Stock Exchange or a retail service provider (RSP) have more depth than multilateral trading facilities2; and

A securities firm should also consider the impact of external factors on the levels of capital it needs to hold. Scenarios covering such external factors should relate to its strategy and business plan. A securities firm might wish to consider the questions in (2) to (7).

(2)

Whether it plans to participate in a one-off transaction that might strain temporarily or permanently its capital.

(3)

Whether the unevenness of its revenue suggests that it should hold a capital buffer. Such an assessment could be based, for instance, on an analysis of past revenue and the volatility of its capital.

(4)

How its income might alter as interest rates fluctuate where it is obliged to pay interest to its clients in excess of interest it earns on client money deposits.

(5)

How its capital would be affected by a market downturn. For instance, how sensitive that firm is to a sharp reduction of trading volumes.

(6)

How political and economic factors will affect that firm's business. For instance, a commodityfirm may wish to consider the impact of a sharp increase in prices on initial margins and, consequently, on its liquidity.

(7)

Whether it anticipates expanding its activities (for example, by offering clearing services), and if so, the impact on its capital.

A securities firm may also want to assess the impact of its internal credit limits on its levels of capital. For instance, a firm whose internal procedures authorise dealing without cash in the account or without pre-set dealing limits might consider more capital is required than if it operated stricter internal credit limits.

Capital models

A firm may approach its assessment of adequate capital by developing a model, including an ECM (see BIPRU 2.2.27 G), for some or all of its business risks. The assumptions required to aggregate risks modelled and the confidence levels adopted should be considered by a firm's senior management. A firm should also consider whether any relevant risks, including systems and control risks, are not captured by the model.

If a firm adopts a top-down approach to developing its internal model, it should be able to allocate the outcome of the internal model to risks it has previously identified in relation to each separate legal entity, business unit or business activity, as appropriate. In relation to a firm which is a member of a group, GENPRU 1.2.53 R (Application of GENPRU 1.2 on a solo and consolidated basis: Processes and tests) sets out how internal capital identified as necessary by that firm'sICAAP should be allocated.

If a firm's internal model makes explicit or implicit assumptions in relation to correlations within or between risk types, or in relation to diversification benefits between business types, the firm should be able to explain to the appropriate regulator, with the support of empirical evidence, the basis of those assumptions.

The values assigned to inputs into a firm's model should be derived either stochastically, by assuming the value of an item can follow an appropriate probability distribution and by selecting appropriate values at the tail of the distribution, or deterministically, using appropriate prudent assumptions. For options or guarantees which change in value significantly in certain economic or demographic circumstances, a stochastic approach would normally be appropriate.

Proportionality

Stress testing for interest rate risk: General requirement

As part of its obligations under GENPRU 1.2.30 R (Processes, strategies and systems for risks) and GENPRU 1.2.36 R (Stress and scenario tests) a firm must carry out an evaluation of its exposure to the interest rate risk arising from its non-trading activities.

(2)

The evaluation under (1) must cover the effect of a sudden and unexpected parallel change in interest rates of 200 basis points in both directions.

(3)

A firm must immediately notify the appropriate regulator if any evaluation under this rule suggests that, as a result of the change in interest rates described in (2), the economic value of the firm would decline by more than 20% of its capital resources.

the ability to measure the exposure and sensitivity of the firm's activities, if material, to repricing risk, yield curve risk, basis risk and risks arising from embedded optionality (for example, pipeline risk, prepayment risk) as well as2changes in assumptions (for example those about customer behaviour);

consideration as to whether a purely static analysis of the impact on their current portfolio of a given shock or shocks should be supplemented by a more dynamic simulation approach; and

(3)

scenarios in which different interest rate paths are computed and in which some of the assumptions (e.g. about behaviour, contribution to risk and balance sheet size and composition) are themselves functions of interest rate level.

Under GENPRU 1.2.60 R, a firm is required to make a written record of its assessments made under GENPRU 1.2. A firm's record of its approach to evaluating and managing interest rate risk as it affects the firm's non-trading activities should cover the following issues:

(1)

the internal definition of and boundary between "banking book" and "trading activities" (see BIPRU 1.2);

(2)

the definition of economic value and its consistency with the method used to value assets and liabilities (e.g. discounted cashflows);

(3)

the size and the form of the different shocks to be used for internal calculations;

(4)

the use of a dynamic and / or static approach in the application of interest rate shocks;

(5)

the treatment of commonly called "pipeline transactions" (including any related hedging);

the treatment of current and savings accounts (i.e. the maturity attached to exposures without a contractual maturity);

(9)

the treatment of fixed rate assets (liabilities) where customers still have a right to repay (withdraw) early;

(10)

the extent to which sensitivities to small shocks can be scaled up on a linear basis without material loss of accuracy (i.e. covering both convexity generally and the non-linearity of pay-off associated with explicit option products);

(11)

the degree of granularity employed (for example offsets within a time bucket); and

(12)

whether all future cash flows or only principal balances are included.

The appropriate regulator will periodically review whether the level of the shock referred to in BIPRU 2.3.7 R (2) is appropriate in the light of changing circumstances, in particular the general level of interest rates (for instance periods of very low interest rates) and their volatility. A firm's internal systems should therefore be flexible enough to compute its sensitivity to any standardised shock that is prescribed. If a 200 basis point shock would imply negative interest rates or if such a shock would otherwise be considered inappropriate, the appropriate regulator will consider adjusting the requirements accordingly.

Stress testing for interest rate risk: Frequency

A firm must carry out the evaluations required by BIPRU 2.3.7 R as frequently as necessary for it to be reasonably satisfied that it has at all times a sufficient understanding of the degree to which it is exposed to the risks referred to in that rule and the nature of that exposure. In any case it must carry out those evaluations no less frequently than required by (2) or (3).